10/12/2009 @ 12:45PM

A Welcome Nobel

This year, the Royal Swedish Academy of Sciences awarded the Nobel Memorial Prize in economics to two Americans, Elinor Ostrom and Oliver Williamson. The description that the Academy gave for its award will sound as dry as dust to people who are not familiar with the nature of economic inquiry.

Ostrom received her prize for showing the various mechanisms that parties can use to control the operations of various forms of common pool resources, e.g., fisheries, in order to prevent their overconsumption and premature exhaustion. Williamson has written extensively on the various devices that are used to control the internal operations of the firm, including internal hierarchies, i.e., permanent relations among individuals in a firm that can be used to eliminate conflicts of interests, and opportunistic behavior in various exchange transactions that might otherwise be conducted on a case-by-case basis.

Issuing the award to these two economists is a welcome trend because it once again leads us to focus on the microeconomic issues that have, when aggregated, macroeconomic consequences. In times of great economic stress, the tendency of many people is to think that the cure for all our social ailments lies in macroeconomics.

Keynes wrote his great treatise on the General Theory of Employment, Interest and Money in 1936, at the height of the Great Depression. Its cure for the various ills of mankind stressed the major interventions that the government could make in monetary policy (which controls the money supply) and fiscal policy (which deals with government expenditures and programs). The basic impulse of this approach is that large problems require large responses–and large government stimuli–which in turn draws attention to money, our most ubiquitous commodity, and to government, our most ubiquitous social institution.

The joint award to Ostrom and Williamson could be read as a needed corrective on this macroeconomic approach. The common thread that links these two authors together is their concern with mid-size institutions that face serious questions of coordination and control. Normally when we think of private ownership, we tend to think of a single owner who has the right to exclude all other persons from a particular resource. The first impression, however, only makes sense in this matter because the single owner acts as a dictator over the resources under his command. Apart from aggressive uses, he normally can be trusted to make efficient decisions for the use and/or consumption of his own resources. Normally, however, matters of governance don’t matter at all in those ownership islands in which a single person can act as a dictator.

Single ownership is by no means a rarity in society, but it is far less common for productive assets than first meets the eye. The simple decision of husband and wife to own property jointly allows them to exclude the world, as before. But it also requires them to figure out how to divide the control over their assets between them. Those problems of joint control are usually handled successfully because the two people are not chosen at random, and usually have a high degree of trust between them. But once assets are placed under the control of a firm that has owners, officers and employees, the conflict of interests and the internal governance issues become a far larger issue.

Williamson was one of the first economists to follow the lead of Ronald Coase (who won his Nobel Prize in 1991) to ask when firms should form, and what kinds of devices firms should use to minimize the (sum of) the costs of conflicts of interest and of their control. The task is far more daunting than it seems, given the wide variation in the size, objectives and resources that these firms uses.

For example, Williamson developed particular explanations as to why two parties might choose to join in a single firm rather than cooperate through a set of spot, i.e., individual, short-term, contracts. In a first-best world of perfect contractual enforcement, the differences will turn out to be negligible, but in any real world setting, they often matter. The same parties that happily agree to a contract on day one may discover that their relationship can easily go sour thereafter. One side may find it difficult to monitor behavior to prevent its partner from taking advantage now that it has become difficult to separate. Or long-term deals could easily leave one party at the mercy of the other, which owns a particular asset that is indispensable the operation of its business.

Putting these complementary resources under a single firm umbrella is one effective device to counteract the weakness of contractual enforcement. Once there, a new governance problem arises, and on that issue Williamson’s discussion of how internal firm hierarchies can control these difficulties ranks as one of the important advances in modern economics.

The issue of common ownership does not only arise with respect to firms that are created by voluntary action, but also for natural resources that are by custom owned collectively, because privately they cannot be managed efficiently. Water is one such resource, over which there can be a wide variety of uses–navigation, recreation, fishing–that are destroyed if any individual can divert all the water into his own barrels.

These resources are best organized in common, while other uses–drinking and irrigation–become the limited private uses of common resources. Left unmanaged, the mix of private and common uses could lead to systematic resource misallocation. Elinor Ostrom is one of the leaders in the movement that seeks to understand what kinds of arrangements can be adopted to coordinate uses of common resources, whether it be a fishing quota on the one hand or a system of taxation to dredge a river on the other.

A short column of this sort cannot begin to describe the complex institutional trade-offs that must be mastered to secure the efficient deployment of these resources. But it is important for these purposes to note that these so-called microeconomic issues quickly multiply. There are thousands of firms and thousands of commons. Generating improvements to all these multiple challenges goes straight to the bottom line. Better management of firm and common resources can increase the level of social production and human satisfaction. In their own way, each of these small adjustments may seem to be of no consequence relative to the big macroeconomic changes. But the small changes are additive in a way the large ones are not. Understanding the processes to which Ostrom and Williamson have devoted their professional lives shows us how quiet ventures, properly executed, can generate immense improvements in individual and social welfare. We all owe them a debt of gratitude.

Richard A. Epstein is the James Parker Hall distinguished service professor of law, the University of Chicago; the Peter and Kirsten Bedford senior fellow at the Hoover Institution; and a visiting law professor at New York University Law School. He writes a weekly column for Forbes.